November 2014

Evaluations of wellbeing complement and encompass established measures of economic progress. This column presents findings on the way governance affects wellbeing. The results indicate that people are more satisfied with their lives in countries with better governance quality. Confidence and trust in public institutions play an important role in this finding. Additional benefits to wellbeing arise when nations are able to better weather economic and other crises.

A breakthrough in understanding the link between growth and inequality came from ‘unpacking’ inequality – looking at inequality measures for different segments of the population rather than just an aggregate measure. This column presents novel research that also ‘unpacks’ growth, investigating the impact of inequality on growth for different groups across the income distribution. Inequality toward the lower end of the distribution hinders growth for the poor, but not for the rich.

The effectiveness of official development aid is the subject of heated debate. This column argues that aid affects recipient economies in extremely complex ways and through multiple and changing channels. Moreover, this is a two-way relationship – realities in recipient countries affect the actions of aid agencies. This relationship is so intricate and time-dependent that it is not amenable to being captured by cross-country or panel regressions. Even sophisticated specifications with multiple breakpoints and nonlinearities are unlikely to explain the inner workings of the aid–performance connection.

The growing importance of sovereign wealth funds and the diffusion of inflation targeting have impacted the adjustment of Latin American Countries to terms of trade and financial shocks. This column shows that sovereign welfare funds provide another margin of stabilisation. This role is of greater relevance for inflation targeting countries and during periods of heightened volatility. Inflation targeting regimes relegate the goal of real exchange rate stabilisation and counter-cyclical fiscal policy to its sovereign wealth fund via a fiscal rule.

The post-Crisis G7 economies have suffered weak business investment despite record low interest rates and the favourable financial positions of corporates. Some consider this the ‘new normal’ arising from secular, supply-side forces that have contributed to declining potential growth rates. This column argues that structural factors alone are not sufficient to explain the current weakness in investment rates. There is thus room for positive surprise if companies realise the pent-up investment demand.

A major concern with multinationals is that they can cause disemployment (also called job offshoring). However, FDI could offset or even exceed such a negative effect. This column examines to what extent disemployment in Japan is related to FDI. The results suggest that disemployment in Japan is driven by substitution between capital and labour, rather than the reallocation of labour caused by FDI.

To reduce the risk of international commerce banks offer specific trade finance products, the most prominent being letters of credit. This column employs US banking data to show that reductions in the supply of such trade finance have considerable effects on the levels and patterns of exports, especially to small and poor countries and during times of financial distress.

The importance of world shocks for the UK economy has been demonstrated by the events since 2007. This column suggests that world shocks are likely to have driven around two-thirds of the shortfall in output since 2007. Trade linkages are an important channel for the transmission of world shocks to the UK, but financial linkages and spillovers through uncertainty are likely to account for the majority of the impact.

The share of compensation to labour in gross value added has declined in recent decades for most countries and industries around the world. Recent work has also used the share of compensation to labour in net value added as a proxy for inequality. This column discusses that gross and net labour shares have declined together for most countries since 1975 – an outcome consistent with the worldwide decline in the relative price of investment goods.

A large literature shows the importance of firm heterogeneity in determining trade patterns. This column discusses policy implementation issues related to the ‘new new trade theory’. The nature of an export good – be it consumption or production oriented – influences the importance of firm productivity in the export decision. The relationship between productivity and markups also varies across industries; pro-export policies must take account of this, lest they exacerbate distortion.

The Great Recession uncovered the difficulties that economic structural models have in explaining the data. This column proposes a methodology that can help identify the sources of mis-specification by introducing exogenous processes. These exogenous processes are not structural shocks but processes that can improve the fit. The results indicate that including more labour and asset frictions in economic models could improve their performance.

Many countries have announced emissions targets for 2020. To evaluate which countries are doing their fair share, this column proposes a ‘scorecard’ approach based on three principles of fairness in climate change mitigation: latecomer catch-up, progressivity, and cost. The authors find that most countries’ targets, including those of China and the US, are in line with what such a scorecard would suggest.

The Great Recession uncovered the difficulties that economic structural models have in explaining the data. This column proposes a methodology that can help identify the sources of mis-specification by introducing exogenous processes. These exogenous processes are not structural shocks but processes that can improve the fit. The results indicate that including more labour and asset frictions in economic models could improve their performance.

The appropriate level of public sector wages is debated frequently in every country, and the debate has intensified in the wake of the global financial crisis. This column presents evidence that regional wage differentials in Japan are greater in the private sector than in the public sector. In regions where public sector wages are relatively high, skilled individuals may self-select into public sector jobs. At the same time, public sector employers in metropolitan regions such as Tokyo may have difficulty in hiring high quality employees.

Patented pharmaceuticals diffuse across international borders slowly, and sometimes not at all. This column analyses the effect of patent protection and price regulation on the speed of and extent to which drugs enter new markets. There is a fundamental tradeoff between affordability – taking the form of low patent protection and strong price regulation – and rate of entry into a national market.

The ECB estimated that Eurozone banks would face a capital shortfall of €25 billion in a severe crisis. Earlier work by the authors estimated the shortfall to be 30 times higher. This column argues that this striking divergence can be explained by the ECB’s reliance on static risk-weights.

Global hyperconnectivity and increased system integration have led to vast benefits in terms of income, education, innovation and technology. Yet globalisation has also created serious concerns about how local events can so easily cascade over national borders to become crises that affect everyone. This Vox Talk discusses the widening gap between systemic risks and their effective management. Goldin argues that the new dynamics and complexities of globalisation are endemic and will potentially destabilise our societies unless they are addressed immediately and more effectively.

One frequently used argument in favour of secession is that there are economic benefits from independence. However, whether or not this is the case remains largely unexplored. This column addresses this question by examining the economic implications of secession in the case of the former Yugoslavia. The authors find that independence had no favourable economic impact. The way secession was achieved, however, mattered. Whereas secession without real conflict did not leave any noticeable economic impact, violent secession has, by contrast, led to a significant destruction of wealth.

The conventional thinking about foreign direct investment is that it may create jobs but also take away market opportunities from domestic firms. This column suggests another spillover to consider. If foreign firms require higher quality inputs, domestic firms who share suppliers with foreign firms gain access to better local inputs. It then argues that this spillover effect can explain a third of the productivity gains within Bangladeshi firms during 1999-2003.

Would the economic benefits of devolving full income tax powers to the Scottish Parliament and Welsh Assembly outweigh the costs? Not according to an overwhelming majority of respondents to the monthly survey of the Centre for Macroeconomics (CFM), summarised in this column. A smaller majority of CFM experts do not accept the economic case for establishing 'English votes for English laws' with the same tax and spending powers as the Scottish Parliament.

Admission to higher education often depends on the results of high-stakes tests, but assessing the consequences of having a ‘bad day’ on such tests is challenging. This column provides evidence from a dataset on Israeli high-school students. Random variations in pollution have measurable effects on exam performance, and these in turn have significant effects on students’ future educational and labour-market outcomes. The authors argue that placing too much weight on high-stakes exams may not be consistent with meritocratic principles.

A common view in international finance is that currency trades make money because high-interest-rate currencies tend to appreciate. This column argues that this view is flawed, suggesting that currency risk premia may be much simpler than previously thought. The carry trade has little to do with the appreciation of the currency, but instead exploits persistent differentials in interest rates across countries. It is thus important to understand why some currencies have persistently higher interest rates than others.

Concerns about inequality are at the forefront of many policy debates. While inequality has increased in many countries over the past few decades, in others it has decreased. This column uses data from 117 countries over the past four decades to investigate the importance of such changes in inequality, as well as of overall economic growth. Whereas inequality changes in most countries have been small, differences in overall growth performance have been large. Policymakers should therefore be careful not to undermine growth in the quest for greater equality.

Futures prices are a potentially valuable source of information about market expectations of asset prices. This column discusses a general approach to recovering this expectation when there is no agreement on the nature of the time-varying risk premium contained in futures prices. The authors illustrate this approach by tackling the long-standing problem of how to recover the market expectation of the price of crude oil.

Results from last month’s EU-wide stress test are reassuring, especially for countries at Europe’s core. This column warns against a rosy interpretation. The test relies on risk-weighted measures of bank capital ratios that have been shown to be less predictive of bank failure than unweighted leverage ratios – a metric already adopted by the US Fed and Bank of England. In addition, many experts recommend much higher leverage ratios than currently required. The ECB must do more to fix undercapitalisation.

Like any insurance mechanism, unemployment benefits involve a trade-off between risk sharing and moral hazard. Whereas previous studies have concluded that unemployment insurance is close to optimal in the US, this column argues that replacement rates should vary over the life cycle. Young people typically have little means to smooth consumption during a spell of unemployment, while the moral hazard problems are minor – regardless of replacement rates, the young want jobs to improve their lifetime career prospects and to build up human capital.

Contingent convertible capital instruments – also known as CoCos – have grown in popularity since the financial crisis. This column suggests that the search for yield and the tightening of capital requirements have resulted in a new wave of CoCo issuances. While many of their features and risks remain unclear, CoCos may act as a buffer that makes banks more resilient in times of crisis.

It is generally agreed that firms can improve their employees’ wellbeing through improvements in job quality – but is it in their economic interests to do so? This column reports research showing that satisfied employees and higher productivity go together. Analysis of the British Workplace Employment Relations Survey finds that employee job satisfaction is positively associated with workplace financial performance, labour productivity, and the quality of output and service.

There are large rewards of higher education in terms of earnings. However, a sizeable fraction of workers hold occupations that not require as much schooling as they have. This column considers the effects of being overeducated on future employment and wages for a representative cohort of Americans. Around 38% of the college graduates in the sample have higher education than the typical worker in their profession. Rather than transitory, the bulk of overeducation persists in the long run. Even if workers manage to transit to better jobs, they experience wage penalties similar to those after unemployment.

The TransAtlantic Trade and Investment Partnership (TTIP) has become a full-blown political issue as the two largest economic entities in the world are negotiating a deep integration agreement, going beyond what has been done previously in any agreement except the EU’s Single Market. This column estimates that a phasing-out of tariffs accompanied by a 25% cut in the trade restrictiveness of non-tariff measures would increase trade in goods and services between the two regions by 50%.

Recent advances in artificial intelligence could affect manufacturing and the labour markets in a number of ways. This column explores two of them. First, it finds no confirmation that machines have decreased the cost of labour and brought manufacturing back to rich countries. Second, it argues that machines could replace highly skilled workers rather than increase the demand for their labour. Technology and skills are thus substitutes not complements.

Optimal tax rates for the rich are a perennial source of controversy. This column argues that high marginal tax rates on the top 1% of earners can make society as a whole better off. Not knowing whether they would ever make it into the top 1%, but understanding it is very unlikely, households especially at younger ages would happily accept a life that is somewhat better most of the time and significantly worse in the rare event they rise to the top 1%.

In Japan, loans with 100% guarantees account for more than half of all loans covered by public credit guarantee schemes, but banks claim that they do not offer loans without sufficient screening and monitoring even if the loans are guaranteed. This column presents evidence of adverse selection and moral hazard in Japanese credit guarantee schemes. The problem is less severe for loans with 80% guarantees.

The current debate on the efficacy of Keynesian stimulus mirrors the resistance Keynes met with when initially advocating his theory. This column explains the original controversy and casts today’s policy debate in that context. Now that concepts of Ricardian equivalence and the fiscal multiplier are formally defined, we are better able to frame the arguments. The authors argue that a simple model of the short-run economy can substantiate the argument for stimulus.

The ECB seems to be edging towards QE, but faces a quandary on what to buy. This proposal suggests that the ECB buy ‘Safe Market Bonds’. These would be synthetic bonds formed by the senior tranches of EZ national bonds combined in GDP-weighted proportions. The ECB would merely announce the features of the synthetic bonds it will purchase. The market would create the bonds in response to this announcement, thus avoiding new EZ-level institutions or funds.

The retreat to protectionism since the Global Financial Crisis has been more severe than previously imagined. Peak protectionism was believed to have passed in 2009. With evidence from the latest Global Trade Alert report, this column shows that since 2012 protectionist measures by G20 countries have exceeded the 2009 peak – which has also been revised upwards. Despite committing to liberalisation, G20 countries have a substantially worse record of protectionism than the next ten largest trading countries.

Forecasts of many macroeconomic variables tend to be serially correlated, which is inconsistent with rational expectations. This column presents new evidence from a two-decade panel of individual forecasts from 36 different nations. While there is evidence of sluggish behaviour in average forecasts, individual forecasts are revised quite often. Sticky information theory might not be an adequate description of the expectations formation of forecasters.

Bankers’ bonuses are increasingly regulated but we know little about how they affect risk-taking and value-creation. Based on payroll data from 1.2 million bank employee-years in Austria, Germany, and Switzerland, this column finds evidence that bonuses affect both profits and risk-taking. Policy thus needs to strike a balance and acknowledge the limited regulatory capacity to determine optimal incentives. Higher capital requirements and shareholder empowerment might outperform simple bonus regulations.

The feedback loop between banking crises and sovereign debt crises has been at the heart of recent problems in the Eurozone. This column presents stylised facts on the mechanisms through which banking and sovereign crises combine and become ‘twin’ crises. The results point to systematic differences not only between ‘single’ and ‘twin’ crises, but also between different types of ‘twin’ episodes. The timing of ‘twin’ crises – which crisis comes first – is important for understanding their drivers, transmission channels, and economic consequences.

Understanding the probability and magnitude of financial contagion is essential for policymaking. This column applies a framework for modelling financial contagion to data on the cross-holding and credit risk of sovereign debt in Europe. Credit markets perceived little risk of contagion from these spillovers following a sovereign default. It is important for policy to assess other possible channels for contagion that could generate even bigger losses.

Many low-income countries and development organisations are calling for greater liberalisation of labour immigration policies in high-income countries. At the same time, human rights organisations and migrant rights’ advocates demand more equal rights for migrant workers. This Vox Talk discusses the tensions between human rights and citizenship rights and argues that you cannot always have both.

The past three years have witnessed a slowdown in global trade. This column shows that the slowdown was particularly pronounced in advanced economies, especially the Eurozone. In a panel of 18 OECD economies, most of the slowdown can be explained by cyclical factors. However, structural factors – global value chains and especially protectionism – may have played a role too.

In the massive circumstances of total war, economic factors play the deciding role. Historians emphasise size in explaining the outcome of WWI, but this column argues that quality mattered as well as quantity. Developed countries mobilised resources in disproportion to their economic size – the level of development acted as a multiplier. With their large peasant sectors, the Central Powers could not maintain agricultural output as wartime mobilisation redirected resources from farming. The resulting urban famine undermined the supply chain behind the war effort.

Economists disagree over the origin of the Eurozone Crisis. This column uses a quantitative framework to sort through the various channels and policy impacts. It argues that fiscal and macroprudential policies are complements, not substitutes. Prudent fiscal policy is helpful but cannot by itself undo private leverage booms. Both prudent fiscal policies and macroprudential policies are required to stabilise the economy and make the Eurozone a viable monetary union.

With WTO trade talks on the brink of failure (again), global trade governance is being decided elsewhere. This column argues that China and the US are pushing competing visions for free trade in Asia-Pacific. The US-led Trans-Pacific Partnership, TPP, could be challenged by a China-led ‘Beijing Road Map’ that may be announced at this week’s APEC summit. Neither vision is an end-game but merely one more stroke on an ugly picture of trade agreements characterised by an unsustainable amount of disorder and incoherence.

The ECB has published the results of its asset quality review and stress tests of Eurozone banks. This column argues that, while this process had clear shortcomings, it still constitutes a huge improvement over the three previous exercises in the EU. Nevertheless, the banking union is far from complete, and the biggest risk now is complacency. A long-term reform agenda awaits Europe.

Although central banks have a natural desire to influence household inflation expectations, there is no consensus on how these expectations are formed or the best ways to influence them. This column presents evidence from a series of survey experiments conducted in a low-inflation context (the US) and a high-inflation context (Argentina). The authors find that dispersion in household expectations can be explained by the cost of acquiring and interpreting inflation statistics, and by the use of inaccurate memories about price changes of specific products. They also provide recommendations for central bank communication strategies.

In the aftermath of the Global Crisis, models with pecuniary externalities have gained popularity. This column presents a new framework that encompasses many of these externalities. The authors also show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation.

While participation in global value chains is giving developing countries the opportunity to diversify production and to acquire know-how from global buyers, few countries in Latin America are taking advantage of these new forms of production. Using a combination of innovative datasets at the macro and micro levels this column presents a comprehensive picture of the participation of Latin America and the Caribbean in global value chains and describes why it is so low.

In December 2008, the Fed lowered the federal funds rate to essentially zero and has kept it there since then. This column argues that, contrary to traditional macroeconomic thinking, monetary policy has not been severely constrained by the zero bound until mid-2011. The results imply that the Fed could have done more to ease monetary policy between 2009 and 2011. These findings could also help explain why the fiscal stimulus package adopted in 2009 did not bring the expected success.

Children born in crises face different initial conditions. Data on children born in East Germany just after the Berlin Wall came down confirms that this corresponds to worse adult outcomes. ‘Children of the Wall’ have 40% higher arrest rates, are 33% more likely to have repeated a grade by age 12, and are 9% more likely to have been put into a lower educational track. This column argues that these negative outcomes can be explained by the lower average parenting skills of those who decided to have children during a period of high economic uncertainty.

A triple-dip recession in the Eurozone is now a distinct possibility. This column argues that additional monetary stimulus is unlikely to be effective, that the scope for further fiscal stimulus is limited, and that some structural reforms may actually hurt growth in the short run by adding to disinflationary pressures in a liquidity trap. The author advocates using tax incentives and tighter regulations to encourage firms to replace environmentally inefficient capital.

It’s a common perception that big cities are expensive. This column argues that most of the variation in prices across cities can be attributed to flaws in the conventional indexes. One problem with the standard methodology is that it compares prices of similar but not identical goods. A second issue is that most price indexes do not adjust for the availability of goods across locations. Correcting for these two problems, the authors find that grocery prices are actually lower in large cities.

A quarter of a century ago, the Iron Curtain and Berlin Wall were demolished. This was one of the most visible consequences of the fall of communism. In the decades before 1989 political conflict had shaped the world trade pattern. Against the background of political tensions in the Ukraine, this column investigates the vulnerability of the world trade system.

Foreign reserve accumulation by China and other east Asian countries has been a controversial way to boost exports. This column argues that it is not even in their own national interests. The policy has been ineffective in maintaining China’s ordinary trade surplus, while its processing trade surplus continues to rely on devaluation in countries further up the supply chain. Foreign reserve divestment would increase purchasing power in east Asian countries, free up government revenue, and be innocuous to export competition if properly coordinated.

How does an autocratic regime domestically counter the impact of economic sanctions? This column studies the impact of sanctions on North Korea using satellite night-time lights data and finds that the burden of sanctions falls on the vulnerable population and not the elites in power towards whom the sanctions are aimed. Sanctions that fail to change the leader’s behaviour likely increase inequality at a cost to the already marginalised hinterlands.

India was among the hardest hit by the Fed’s ‘taper talks’. This column argues that this impact was large for two reasons. First, India received huge capital flows before 2013. This had made it a convenient target for investors seeking to rebalance away from emerging markets. Second, macroeconomic conditions had worsened, which rendered the economy vulnerable. The measures adopted in response were ineffective in stabilising the financial markets. Implementing a medium-term framework that limits vulnerabilities and restricts spillovers could be more successful.

In the aftermath of the Global Crisis, policymakers and academics alike discussed how uncertainty surrounding macroeconomic policymaking has impacted domestic investment. At the same time, concerns regarding the spillover impact of monetary policy in advanced economies on emerging market economies featured strongly in the international policy debate. This column draws the two debates together, and examines how policy uncertainty in advanced economies has spilled over to emerging markets via portfolio capital flows. It finds remarkable differences in the spillover effects of EU vs. US policy uncertainty.

Data on social attitudes show that the perceived burden of immigration on a nation’s public finances is one of the strongest economic concerns associated with hostility to immigration. Yet recent official reports suggest an important positive role for immigration in the long-run health of public finances. This column argues that there can be no general conclusions applicable in all circumstances about whether immigration is favourable or unfavourable for public finances. But evidence is emerging on particular cases through studies of immigrant composition and use of services, and the effects of immigration on native outcomes.

How should researchers investigate the true role of people’s self-reported social links in getting a job, getting a favour or simply getting information? This column introduces a framework to estimate the process by which people’s self-reported social links are formed. The authors show that different link formation rules predict the different network structures seen in data from a risk-sharing survey in a Tanzanian village and the diffusion of agricultural knowledge in the Indian state of Maharashtra.

Most of the world is now at the point where the support ratio is becoming adverse, and the growth of the global workforce is slowing. This column argues that these changes will have profound and negative effects on economic growth. This implies that negative real interest rates are not the new normal, but rather an extreme artefact of a series of trends, several of which are coming to an end. By 2025, real interest rates should have returned to their historical equilibrium value of around 2.5–3%.

Eurozone countries need to stop the stagnation and improve their management of future crises. In this column, the authors argue that both issues should be addressed simultaneously. To achieve this goal, they propose the creation of a European Federal Institute. This Institute would coordinate short-run anti-recession measures, and implement steps towards a federal budget that would fix the European institutional design in the long run.

There has been a long-term downward trend in labour’s share of national income, depressing both demand and inflation, and thus prompting ever more expansionary monetary policies. This column argues that, while understandable in a short-term business cycle context, this has exacerbated longer-term trends, increasing inequality and financial distortions. Perhaps the most fundamental problem has been over-reliance on debt finance. The authors propose policies to raise the share of equity finance in housing markets; such reforms could be extended to other sectors of the economy.

Contrary to widely held beliefs, the world has not yet begun to ‘delever’ and the global debt-to-GDP is still growing. Growth and inflation are also dangerously low. This Vox Talk discusses the findings and policy recommendations of the 16th Geneva Report. It argues that much more can and should be done to improve resilience to debt shocks and discourage excessive debt accumulation.

The Fed is stretching out its zero interest-rate policy waiting for labour market improvements. As unemployment fell the emphasis shifted to wages, which are an even more problematic measure of economic conditions. Basing monetary policy on a notoriously long cyclical laggard is prone to policy mistakes. This column argues that moving up rate hikes would be wise and prudent.

The impact of the stock and maturity of government debt on longer-term bond yields matters for monetary policy. This column assesses the magnitude and relative importance of overall bond supply and maturity effects on longer-term US Treasury interest rates using data from 1976 to 2008. Both factors have a significant impact on both forwards and term premia, but maturity of public debt appears to matter more. The results have implications for exit from unconventional policies, and also for the links between monetary and fiscal policy and debt management.

House price fluctuations take centre stage in recent macroeconomic debates, but little is known about their long-run evolution. This column presents new house price indices for 14 advanced economies since 1870. Real house prices display a pronounced hockey-stick pattern over the past 140 years. They stayed constant from the 19th to the mid-20th century, but rose strongly in the second half of the 20th century. Sharply increasing land prices, not construction costs, were the key driver of this trend.

Recent scandals involving some financial benchmarks have shaken the confidence in them. Regulators have responded with sanctions and with actions to support more robust benchmarks. This column presents new research on how a benchmark administrator would optimally weigh transaction prices to produce a fixing. Weights assigned to the observed prices should be increasing in the size of the transactions. However, in this setting, it is typically impossible to implement a benchmark in a complete absence of manipulation.